SMEs

I recently conducted a literature review on the impact of tax reforms on private sector development as part of the Investment Climate Impact Project.1 My goal was to take stock of what is currently known about the impact of reforms that the World Bank is supporting in this area and to identify the gaps in knowledge that we ought to fill by conducting more impact evaluations. While tax reforms can have a broad range of effects in the economy, the focus here was on private sector outcomes only, as measured by investment, tax evasion by formal firms, formal firm creation, and firms’ economic performance.

It turns out that most papers in this area study the impact of changing tax rates. Both cross-country and micro-level studies suggest that lowering tax rates can increase investment, reduce tax evasion, promote formal firm creation and ultimately lead to an increase in firms’ sales and GDP growth overall. However, lowering tax rates also has important implications for government revenue and it is thus often difficult to balance the trade-offs between various goals of public policy.

Last week I presented some early findings from ongoing work at the IADB, at Innovations for Poverty Action’s SME initiative inaugural conference. There was a lot of interesting discussion about early results from efforts to improve management and skills in small and medium firms, discussion of the most appropriate ways of financing these firms and the extent to which a personal vs automated approach to determining creditworthiness can be used, and an interesting panel on policies towards the missing middle. However, the one theme that has got me thinking the most is something that seems to come up a lot in discussions of microenterprise development and SME programs recently, namely should development institutions and policymakers be directing fewer resources at microfirms and more at high-growth-potential enterprises or gazelles?

Gazelles are defined by the OECD to be all enterprises up to 5 years old with average annualised growth greater than 20% per annum, over a three year period, and which have 10 or more workers. Recent work in the US, and looking at firms around the world have emphasized the role of a subset of dynamic, fast-growing young firms in net job creation, leading to policymakers and practioners focused on job creation to think we should be devoting more effort to identifying and supporting these gazelles, and decrying the lack of venture capital markets in developing countries. For example, see this scoping note by Tom Gibson and Hugh Stevenson at the IFC.

These days, job creation is a top priority for policymakers. What role do small and medium enterprises (SMEs) play in employment generation and economic recovery? Multi-billion dollar aid portfolios across countries are directed at fostering the growth of SMEs. However, there is little systematic research or data informing the various policies in support of SMEs, especially in developing countries. Moreover, the empirical evidence on the firm-size growth relationship has been mixed. Recent work of Haltiwanger, Jarmin, and Miranda (2010) in the U.S., suggests that (1) Startups and surviving young businesses are critical for job creation and contribute disproportionately to net growth and (2) There is no systematic relationship between firm size and growth after controlling for firm age. It is not clear whether these findings apply in developing countries where there are greater barriers to entrepreneurship, and where venture capital markets that finance young firms are not as well developed as in the US.

In a recent paper Meghana Ayyagari, Vojislav Maksimovic and I put together a database that presents consistent and comparable information on the contribution of SMEs and young firms to total employment, job creation, and growth across 99 developing economies. Our sample consists of 47,745 firms surveyed in the period 2006-2010. We then examine the relationship between firm size, age, employment, and productivity growth and how this varies with country income and find the following:

Small and medium-size enterprises (SMEs) account for close to 60 percent of global manufacturing employment. So it is no surprise that financing for SMEs has been a subject of great interest to both policymakers and researchers. More important, a number of studies using firm-level survey data have shown that SMEs perceive access to finance and the cost of credit to be greater obstacles than large firms do—and that these factors really do constrain the growth of SMEs.

In recent years a debate has emerged about the nature of bank financing for SMEs: Are small domestic private banks more likely to finance SMEs because they are better suited to engage in “relationship lending,” which requires continual, personalized, direct contact with SMEs in the local community in which they operate? Or can large foreign banks with centralized organizational structures be as effective in lending to SMEs through arm’s-length approaches (such as asset-based lending, factoring, leasing, fixed-asset lending, and credit scoring)? And how well do state-owned banks—for which expanding access to finance is often among their top objectives—serve SMEs?

Many countries in the Middle East and North Africa (MENA) region have established partial credit guarantee schemes (PCGs) to facilitate SME access to finance. These guarantee schemes can potentially play an important role, especially in a period where MENA governments are still making efforts to reduce risks for lenders by improving the effectiveness of credit registries and bureaus and strengthening creditor rights. However, the contribution of credit guarantee schemes to SME finance depends largely on their design.

Well designed schemes may be able to achieve significant outreach and additionality, i.e. benefit a significant number of SMEs that have substantial growth potential but are effectively credit constrained due to lack of credit information and collateral. In some countries PCGs have also played an important capacity-building role. By contrast, poorly designed guarantees schemes may have a limited development impact by providing guarantees to firms that are not credit constrained. PCGs may also accumulate losses by providing overly generous and underpriced guarantees, and ultimately become a burden to public finances.

How much does management matter for economic performance? Despite a large industry of business schools, consulting firms, and airport books purporting to teach you the secrets of good management over the course of your next flight, the answer until very recently has been “we don’t know”. In a recent review, Chad Syverson goes as far as to say “no potential driving factor of productivity has seen a higher ratio of speculation to empirical study”.

Together with colleagues from Stanford and Berkeley, I have been working for the last couple of years to try and understand how much management matters by means of a randomized experiment among textile factories in India. In common with most firms in developing countries, the firms (with 300 workers on average) we were working with did not collect and analyze data systematically in their factories, had few systems for regular maintenance and quality control, had weak human resource systems for promoting and rewarding good performers, and had little control over inventory levels. The result was a high level of quality defects, large stockpiles of unorganized inventories, and frequent breakdowns of machines. 20 percent of the labor force was occupied solely in checking and repairing defective fabric (see picture).

With millions around the globe feeling the impact of the financial crisis and slower economic growth and job losses, it is important to understand regulatory and policy constraints on entrepreneurs wanting to start a formal business. Entrepreneurial activity is the basis of sustainable economic growth, and the first step for entrepreneurs joining or transitioning to the formal sector is the registration of their business at the registrar of companies. For evidence of the economic power of entrepreneurship we need look no further than the United States, where young firms have been shown to be an important source of net job creation, relative to incumbent firms (Haltiwanger, et al.).

To measure entrepreneurial activity, we’ve constructed with support from the Kauffman Foundation the World Bank Group Entrepreneurship Snapshots (WBGES) – a cross-country, time-series dataset on new firm registration in 112 countries. The main variable of interest is “Entry Density”, defined as the number of newly registered limited liability firms as a percentage of the working age population (in thousands). We employ annual figures from 2004 to 2009 collected directly from Registrars of Companies and other government statistical offices worldwide. Like the Doing Business report, the units of measurement are private, formal sector companies with limited liability.

Small and medium-size enterprises (SMEs) are increasingly a priority for policymakers in the Middle East and North Africa (MENA) region, who see SMEs as key to solving the challenge of improving competitiveness, raising incomes, and generating employment. Data from the World Bank’s Enterprise Surveys suggest that access to finance for SMEs is more constrained in MENA than in other emerging regions, with only one in 5 SMEs having a loan or line of credit. Yet until recently there has been no comprehensive survey of the supply of SME finance in MENA. SME policymakers may therefore lack comprehensive information to design reforms, while SME finance providers may not have access to valuable market information to inform design of SME financial services and delivery channels.

To fill this knowledge gap, the Bank recently carried out a survey in cooperation with the Union of Arab Banks of SME lending in the region. We were fortunate to receive a very high response rate – we have data from 139 banks, which account for about half of MENA banks and almost two thirds of the banking system loans in 16 countries. The survey covered the following themes: i) strategic approach to SME lending, ii) main products offered to SMEs, iii) risk management techniques employed, and iv) SME lending data. This is the first dataset of its kind for this region, and builds on similar efforts in the Latin America and Caribbean region.

It is well established that financial development is necessary for the efficient allocation of capital and firm growth, yet firm-level surveys have repeatedly found access to finance to be among the biggest hurdles to starting and growing a new business. For instance, in the World Bank’s Enterprise Surveys standardized dataset for 2006-2009, 31% of firm owners around the world report access to finance as a major constraint to current operations of the firm, while this figure is 40% for firms under three years of age.

In a recent paper with Larry Chavis and Inessa Love we address two types of questions: (1) What is the relationship between firm age and sources of external financing? and (2) Is there a differential impact of the business environment on access to financing by young versus old firms?

To summarize, we find systematic differences in the use of different financing sources for new and older firms. We find that in all countries younger firms rely less on bank financing and more on informal financing. However, we also find that young firms have relatively better access to bank finance in countries with stronger rule of law and better credit information and that the reliance of young firms on informal finance decreases with the availability of credit information.

The costs of excessive regulatory burdens can stifle incentives for firms to innovate, invest and grow. In recent years, aid agencies and developing countries have been stepping up efforts to reduce numerous and lengthy regulatory procedures. However, the focus on aggregate measures of regulatory burden for a country and relying on measures of formal requirements misses a lot of the action.

The World Bank has interviewed over 100,000 entrepreneurs and senior managers in over 100 countries as part of its Enterprise Surveys project. Among the measures collected is the de facto time it takes businesses to complete various interactions with the government (e.g., the time to get goods through customs, get a construction permit, or get an operating license). In the chart below, each vertical line represents a country, and the length of the line represents the distribution of time for firms to clear goods through customs. The first thing to notice is just how much variation there is – within individual countries. There are favored firms for whom it takes a couple of days to obtain permits or clear customs – and disfavored firms, for whom the wait can be weeks or even months. The variation within most countries is considerably larger than the differences in averages across countries.